Friday, January 30, 2009

Banks: Risks and Exposures

  
TD Securities, 30 January 2009

• The risks/exposures you need to know about. We highlight the key risks and exposures for each name that are most likely to present challenges over the coming year across investment portfolios, derivatives and off-balance sheet exposures.

• Further impacts look manageable. Disclosure is limited and visibility is poor, but the worst exposures have been materially reduced and accounting treatment has become more flexible. We expect further write-downs, but they should be manageable relative to the respective platforms, improved capital levels and earnings generation

• Risk of another downturn. That said, the group is far from immune and another wave of financial/economic distress could offer potentially material downside risks in some cases.

• Disclosure still needs more work. Industry disclosure has evolved materially over the past year. Our work reflects our understanding of the available disclosure and additional clarification and discussion with the companies. However, there are still large pools of assets where there is little insight available and there is always the risk of new or completely unexpected exposures.

• Avoid higher risk/exposure business models. Against this backdrop, we continue to avoid those platforms with higher potential for exposure. In our view, Bank of Montreal appears most susceptible to incremental negative developments in a downturn. Royal’s business mix could also offer challenges amid further capital markets distress.

Investment Summary

We believe that 2008 will mark the low point for the Canadian banking industry with respect to the magnitude of asset write-downs and in terms of their shock value and disruptive impact on the industry and investor perceptions. Over the past year, disclosure and understanding has improved materially, while management teams have made significant strides in reducing exposures and rebuilding capital.

In the context of expected continued weakness in capital markets and the global financial system we anticipate further asset write-downs in 2009 across the group. However, they should be manageable relative to the respective platforms, capital levels and ongoing earnings generation.

Visibility remains relatively low, but with a number of the most problematic positions already materially reduced, and the introduction of increased accounting flexibility (i.e. the shift from Trading to Available for Sale) we do not expect to see amounts materially above several hundred million (pre-tax) from a given company in a given quarter.

There are still, however, some significant risks that could develop should we see another significant leg down for the industry such as the failure of another major global financial institution or the collapse to commercial paper markets (we view both examples as remote). As always, there is also a risk of completely unknown or new exposures.

Given the limited visibility and continued risk of further disruptions, our bias remains to avoid platforms with relatively large or broad based businesses that increase the potential for contact with troubled areas or where visibility is limited such as large trading and investment operations. As we discuss, Bank of Montreal has a number of issues to manage. Our review also highlights Royal Bank as a platform with a relatively outsized exposure to trading and investments.

In our 2008 Canadian Banking Handbook (November 3, 2008), we identified what we thought were the key Risk Hot Spots going forward. We have updated that commentary with this report.

1) Securities Trading and Investment Portfolios. Most integrated banking models have substantial asset portfolios as a result of facilitating various forms of client activity as well as proprietary investment strategies. Depending on how management positions the bank, weak capital markets can result in potentially sizeable losses. The industry has focused on a handful of particularly troublesome assets that have come to light, but banks have sizeable portfolios with limited disclosure to assess.

2) Derivative Exposures. Banks have massive derivative portfolios relating to credit, interest rate and foreign exchange risk. Most of the books are run on a matched basis, but remain subject to significant counterparty risk. Here too, disclosure is limited to areas of known problems, specifically the monoline insurance providers. However, the failure of a significant global financial institution posses significant risks, as was the case with Lehman.

3) Off-balance Sheet Exposures. In our view, this category holds one of the potentially largest risks, should we see another leg down in the current downturn. The ABCP (asset backed commercial paper) market is a significant source of financing for a wide range of credit financing. Not only do banks use it directly as a source of funding their own assets, but they also backstop (through liquidity commitments and forms of loss protection) a wide range of other facilities for clients and investment purposes. There have been some relatively isolated problems to date where banks have had to take responsibility for trouble assets or participate in restructurings. That said, the bulk of the assets are for the most part relatively plain vanilla and are of relatively high quality. To date the commercial paper market has continued to function reasonably well, although at materially wider spreads with less liquidity generally. However, if this industry were to seize up, banks could find their exposures increasing rapidly as the conduits drawn down on liquidity facilities that effectively transfer risk to the banks.

The key risks/exposures you need to know about

Bank of Montreal. We cannot define an impending material risk, but the bank has a number of potential problem areas under a downturn scenario including its investment in troubled assets originated in its U.S. ABCP conduits and ongoing liquidity facilities, efforts to support two SIV conduits and multiple exposures to a conduit of levered CDS exposure.

Scotiabank. The bank has weathered the downturn reasonably well and has been among the most proactive in rooting out and isolating exposures. The bank maintains a sizeable ABCP conduit program, but to date the assets have held up well. The bank is somewhat unique in its relatively outsized exposure to the auto sector. Exposure is mainly on the lending side, but the bank has invested in a structured product that holds consumer auto loans from GMAC. The product is conservatively structured and to date the bank has seen relatively minor mark-to-market losses which it views as temporary.

CIBC. The bank suffered materially in 2008 having found itself with significantly outsized exposures to extremely toxic assets. However, combined with substantial write-downs on the worst assets, management is effectively working down and isolating the situation. From here, additional write-downs are likely to be modest relative to what the platform has already endured, although the notional exposure remains substantial. Further, while it may appear remote at this juncture, we believe the possibility remains for substantial recoveries over the coming years.

National Bank. The bank appears to have avoided a worst case scenario with the success of restructuring efforts under the Montreal Accord, although there are ongoing exposures. Otherwise, the bank has very limited exposures to identified problem areas.

Royal Bank. The bank has managed to avoid any dramatic challenges, however it has suffered from a range of smaller exposures and write-downs. There is no single issue that alarms us, but across its businesses the bank has accumulated a number of watch items and overall has relatively outsized exposure to trading/investment activities that offer the opportunity for problems in a downturn.
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Wednesday, January 28, 2009

TD Bank Sees Rising Loan Losses; No Dividend Cut

  
Reuters, 28 January 2009

Toronto Dominion Bank's chief financial officer expects its provision for credit losses to increase this year as the effects of the recession deepens, but she remained confident that Canada's second-largest bank would not cut its dividend.

For all of 2008 the big Canadian bank had provisions for credit losses at just under C$1.1 billion ($827.1 million), which represented about 0.54 percent of its total loans, Colleen Johnston, the bank's chief financial officer said during an industry conference in New York on Wednesday.

Johnston was not certain by how much the bank's provisions for losses would increase in 2009, but added that it was not its "base case" to allow the level to double to 1 percent.

The bank's ability to absorb bad loans has been questioned by analysts recently, but Johnston moved to assure investors that it was in good shape.

"The high quality of our loan portfolio and our disciplined credit culture has served us very, very well in this current credit environment," she said. "We do continue to expect to be a positive outlier in terms of our credit performance."

Canadian banks are facing a fallout from the global economic and stock market downturn, such as weaker profits from wealth management and rising loan loss provisions.

Loan loss provisions are set aside by the banks for bad loans such as customer defaults.

Johnston also said that the bank was expected to move through 2009 without cutting its dividend. The bank, which was the only Canadian bank to increase its dividend twice in 2008, declared a quarterly dividend of 61 Canadian cents in December.

The CFO said the bank has managed its dividend at the low end of its payout range giving it more leeway as earnings slow down or decline, adding that the bank's dividend growth would track its earnings growth.

"Frankly we do not see a scenario where we would consider cutting our dividend," she said.
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RBC Capital Markets, 26 January 2009

Opinion

Pressure on fair values of securities has resulted in a higher level of unrealized losses in the banks' available-for-sale (AFS) portfolios.

• We believe unrealized losses will grow again in Q1/09 as spreads on structured finance assets have continued to widen since Q4/08 ended, cash bonds are also trading at wider spreads and the value of hedges with monolines would have come down given wider spreads on the credit default swaps on those companies.

For unrealized losses on AFS securities to impact earnings and Tier 1 ratios, bank managements have to deem valuation declines as permanent, which is assessed each quarter. We believe there are two primary factors that would influence that view:

• A change in the underlying credit quality, which would impair cash flows. Important factors to track for CDOs of corporate debt, CLOs, ABCP with CDOs of corporate debt are corporate defaults. An increase in corporate defaults would reduce subordination in those structures and might cause managements to question their assumptions. For RMBS and CMBS, default rates and real estate prices are important factors to follow.

• The length at which assets trade below their book value, which likely forces managements to question their valuation assumptions. Unrealized losses are deemed temporary when managements can argue that a liquidity discount is the primary reason as to why there can be gaps between current market prices of securities and the expected realization of value closer to the maturity of the assets. We believe that, when asset prices are below accounting values for an extended period, managements may be more likely to deem some of the valuation declines as permanent.

While we accept the fact that many unrealized losses on AFS securities are temporary in nature, and can be offset by unrealized gains, banks with greater unrealized loss balances on AFS securities are more at risk of potential writedowns down the road that impact Tier 1 capital, all else being equal.

• Relative to Tier 1 capital, gross unrealized losses (before unrealized gains) are highest at TD, BNS and RY. The banks also have gross unrealized gains on AFS securities, although some of these could potentially be realized to offset losses, and our analysis assumes that writedowns happen in a vacuum, which is overly conservative as it gives no credit to the earnings banks generate on a "core" basis.

• That is one reason why, when assessing relative capital strength, we believe investors should consider both Tier 1 ratios (the most important for the Canadian regulator) and tangible common equity (TCE) ratios as TCE ratios are more stringent in that they only include the strongest form of capital and they take into account unrealized losses (and gains) on AFS debt securities.
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Friday, January 23, 2009

RBC's Exposure to Stable Value Products

  
Dow Jones Newswires, 23 January 2009

There may be more scuds hidden deep in Royal Bank of Canada's books - this time in the form of stable value products, a type of insurance on fixed-income portfolios. State Street took $450M in 4Q charges on these products, and BMO Capital Markets notes RY has C$24.9B of exposure. While losses would be substantially lower, BMO says the "odds are rising" that RY may have to take a charge in future quarters. Even a complete write-down is manageable, BMO notes, although the question remains why RY's Capital Markets unit had any involvement in these products in the US at all.
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Financial Post, Jonathan Ratner, 23 January 2009

Shares of Royal Bank are taking another beating after BMO Capital Markets analyst Ian de Verteuil said he is concerned about the bank’s exposure to stable value products and potential charges it make take as result. However, he said the bank’s scale, with more than $27-billion of Tier 1 Capital and earnings of more than $5-billion, means even a "virtually impossible" complete writedown of its bank-owned life insurance (BOLI) shortfall would not be a major problem.

Nonetheless, the analyst said there will be questions as to why Royal is involved in this business – part of capital markets, not insurance – in the U.S at all.

“Based on the bank’s description, Royal sells these products to financial intermediaries or plan sponsors so that these customers can have book value protection on portfolios of intermediate and short-term fixed income products,” Mr. de Verteuil told clients.

The analyst’s focus on this area was highlighted by State Street Corp.’s year-end results, in which the bank took a US$450-million charge against its stable value fund protection.

Mr. de Verteuil noted that Royal Bank disclosed $24.9-billion of exposure to stable value products in its annual report.

“This is the maximum potential amount of future payments, but certainly far exceeds the potential loss that Royal Bank could incur from these products,” he said, adding that the bank provided fewer details before 2008 likely because the perceived risks were minimal.

The analyst also pointed out that Royal disclosed that the shortfall of the BOLI product exceeded $2-billion as of October 2008, while there is no disclosure on whether the $15.4-billion of ERISA (U.S. Employee Retirement Income Security Act) product has a meaningful shortfall.

Mr. de Verteuil said it is quite likely that the shortfall, inclusive of any ERISA shortfall, will approach $3-billion at the end of the bank’s first quarter.

“This amount is well less than the $24.8-billion notional amount, but it is still a large number,” he said. “We have no idea about the likelihood or the potential size of a Royal charge in the coming quarters, but we believe the odds are rising.”

Mr. de Verteuil doesn’t think any other Canadian bank has exposure to BOLI stable value products. He prefers CIBC, BMO and National Bank, “whose problems are well-defined and where the valuations are more attractive.”
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Friday, January 16, 2009

Dundee Securities Downgrades RBC & TD Bank to 'Sell'

  
Financial Post, Jonathan Ratner, 16 January 2009

Both Royal Bank and Toronto-Dominion Bank were downgraded to a “sell” at Dundee Securities on expectations for weaker credit quality, bringing them in line with the firm’s bearish view on the sector as a whole and its recommendations for all of the Big 5 banks.

Despite significant deterioration in its U.S. loan portfolio’s credit quality, Royal’s earnings have held up reasonably well on the back of its domestic retail banking programs, analyst John Aiken told clients. However, since Canada is unlikely to escape the “economic carnage” occurring in the U.S., he said it is only a matter of time before domestic credit quality begins to weaken materially, as credit card exposures have already started to show.

“Consequently, although Royal will likely fair relatively well and should retain a premium to the group, absolute risk still exists,” Mr. Aiken said, cutting his price target on the stock from $38 per share to $35. It closed at $34.04 on Thursday.

His forecast for TD moves from $51 to $44 as a result of expectations for a challenged outlook in the coming quarters as a result of additional deterioration in credit quality. It ended the day at $44.05.

While Mr. Aiken said TD’s operations remain strong and its long-term prospects are solid based on its U.S. growth platform, he thinks 2009 will be the second straight year of declining earnings.

“TD will not be immune and we believe that there is a risk that current expectations for credit losses have a significantly greater chance of being too low rather than too conservative,” the analyst said.

Mr. Aiken did upgrade Laurentian Bank from a “sell” to “neutral,” but lowered his price target from $36 to $33. The stock closed at $31.41 on Thursday.

“We believe that Laurentian’s valuation is much more reasonable at these levels,” he said, adding that while the bank does not have any direct exposure to the U.S., it will still feel pain on the domestic front.

In general, Mr. Aiken feels the impact of underlying economic weakness and credit woes in the U.S., which has produced an earnings drag, increased write-downs and higher loan loss provisions, has also filtered into the Canadian market and will likely linger into the first half of 2009.

“Consequently, we believe that headwinds to the banks’ earnings and concerns of capital adequacy will remain in the forefront as the banks begin the journey into 2009, and with it, the remaining perils from the past year, plus those yet unknown,” he said.

As a result, the analyst said now is not the time to change his cautionary stance on the sector. Instead, he said it is time to remain “selective and mindful.”

Mr. Aiken suggested that strong domestic operations should bode well for the retail market leaders TD, Royal and to a lesser extent CIBC. He also expects higher provisioning will come from the U.S. exposures of TD, Royal and Bank of Montreal, as well as the ripple effects to Bank of Nova Scotia’s Latin America assets.

“Overall, valuation outlook will be largely predicated on the depth and breadth of the U.S. economic slowdown,” the analyst said. “Further credit deterioration will result in higher provisions, while added margin compressions will also depress earnings, offering little justification for any meaningful near term increase in valuations.”
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Wednesday, January 14, 2009

Preview of Life Insurance Cos Q4 2008 Earnings

  
RBC Capital Markets, 14 January 2009

Q4/08 results to be weak in our view

We expect the four lifecos to report YoY declines in earnings per share, driven by difficult conditions in equity and credit markets.

• Our EPS estimates for Manulife are in line with consensus, while they are well below for the other three companies.

• Directionally, the short-term pressure on earnings is greatest on Manulife, in our view, driven by greater exposure to equities. Great-West faces the least near-term pressure in our view.

• Sun Life has the most exposure to deteriorating credit while Great-West and Industrial Alliance have the least, in our view.

• We think the street will lower 2009 earnings estimates following the release of Q4/08 results.

Recent regulatory capital changes are positive

The Office of the Superintendent of Financial Institutions Canada (OSFI) announced proposed revisions to guidelines on capital adequacy late in the quarter.

• OSFI revised the methodology for calculating available capital whereby it will no longer require lifecos to reflect unrealized gains and losses on available for sale (AFS) debt securities in available capital - a positive for all four lifecos, but probably most so for Manulife and Sun Life.

• Segregated fund changes include the previously announced rule changes from October (see our report dated November 7, 2008 entitled "Primer on segregated funds/variable annuities" for more information), as well as allowing greater credit for effective hedges of segregated fund guarantee risk. We think the latter is most positive for Sun Life and the former is most positive for Manulife.

Lifeco stocks are a levered play on equity markets

We believe that the lifecos' shares offer attractive value relative to their long term earnings power, and what should be a better year in 2009 but the catalysts near term are not obvious, especially since we believe that street estimates for Q4/08 profitability are way too high.

We prefer the life insurance sector to the bank space

While we might be early with our call, we expect equity markets to rebound before the economy does and the lifecos have more exposure to equity markets while the banks have more exposure to the real economy. Furthermore, three of the four lifecos have strengthened their capital bases via either equity issues or the sale of a large stake in a publicly-traded company (in the case of Sun Life), which, combined with recent regulatory capital changes, increase the companies' cushions against declines in equity markets.

Company-specific highlights

Great-West Life (February 12)

• We expect Q4/08E operating EPS of $0.44, below consensus estimates of $0.52. Our EPS estimate represents a decline of 26% versus Q4/07 and 9% sequentially, as the company’s earnings continue to suffer from weak credit and equity markets.
• Our estimated Q4/08 hit from equity markets is $180 million ($0.20 per share).
• We expect experience gains and changes in assumptions to be negatively impacted by reserve strengthening for segregated funds, equities that back policy liabilities as well as those that back surplus capital.
• We do not expect credit-related costs to be as large in Q4/08 as they were in Q3/08, as the collapse of a number of previously highly-rated U.S. financial institutions had a negative impact on GWO’s earnings ($95.5 million or $0.11 per share). In Q4/08, while we expect lower pressure on earnings from impairments, we expect continued reserve strengthening as the ratio of downgrades to upgrades of high yield bonds continued to climb in Q4/08. (Exhibit 7)
• We expect Putnam to report assets under management of approximately US$106 billion as at the end of Q4/08, down 43% YoY and 22% sequentially. We forecast a pre-tax margin of 3.0% in Q4/08, well down from 25.5% in Q4/07 but an improvement from the negative 5.2% margin reported in Q3/08.
• Management reviews goodwill yearly (in Q4/08). We believe that some of the $3.5 billion in goodwill and intangibles related to Putnam could be at risk of being marked down as AUM have dropped from US$192 billion in February 2007 when the acquisition was announced to US$106 billion at the end of December.
• We expect U.S. operations, which includes Putnam and financial services, to generate $26 million of earnings in Q4/08 compared to $141 million in Q4/07. The primary differences versus Q4/07 are the negative impacts from credit and equity market weakness and the sale of the healthcare division (which closed on April 1, 2008).
• We expect the mid-Q1/08 $13 billion acquisition of Standard Life’s payout annuity block of business to positively impact Q4/08 earnings for the European division, but will likely largely offset by weakness in global credit and equity markets.
• We expect currency translation to positively impact Q4/08E earnings by approximately 5% versus Q4/07, as reduced earnings in the U.S. somewhat temper the positive effect of a 19% average increase YoY in the U.S. dollar versus the Canadian dollar.

Manulife (February 12)

• We expect Q4/08E core EPS of ($0.99), in line with consensus estimates. Our EPS estimate is well below the $0.75 reported in Q4/07 and $0.33 reported in Q3/08.
• On December 2nd, management provided guidance based on November 30, 2008 equity market levels. The Q4/08 expected loss, announced at the same time as the equity issue, was $1.5 billion, or approximately $0.98 per share.
• The loss would be primarily driven by reserve strengthening for segregated fund/variable annuity guarantees (which we estimate was a $1.8 billion after-tax hit). Equities that back policy holder liabilities as well as surplus capital would also have accounted for a portion of the loss (we estimate a $500-700 million after-tax impact).
• Global equity markets ended the quarter up only marginally from levels on November 30, 2008.
• We do not expect credit-related costs to be as large in Q4/08 as they were in Q3/08, as the collapse of a number of previously highly-rated U.S. financial institutions had a negative impact on MFC’s earnings ($253 million or $0.17 per share). In Q4/08, while we expect lower pressure on earnings from impairments, we expect continued reserve strengthening.
• We expect year-over-year growth in the Value of New Business (VNB) to be muted, hindered by weak expected wealth management product sales given the state of equity markets globally, and by our expectation that insurance sales (outside the U.S.) will also begin to slow following five consecutive quarters of double-digit year over year increases in sales. Insurance sales in Japan should continue to show solid YoY growth due to product introductions and expanded distribution.
• We expect currency fluctuations to positively impact earnings by approximately 7% this quarter versus Q4/07, as strength in the U.S. dollar versus the Canadian dollar and Japanese Yen versus the U.S. dollar (beneficial for MFC) are somewhat offset by weak expected results out of non-Canadian divisions. Manulife’s U.S., Hong Kong, Japanese and reinsurance operations typically account for almost 70% of earnings.

Sun Life (February 12)

• We expect Q4/08E core EPS of ($0.20), well-below consensus estimates of $0.33. Our EPS estimate represents a decline of 120% versus Q4/07, but an improvement from the $0.71 loss in the prior quarter. We believe consensus estimates do not fully reflect the negative impact from equity market weakness during the quarter.
• Our estimated Q4/08 hit from equity markets is $672 million ($1.20 per share). Management has disclosed that each 10% decline in equity markets would reduce net income by $200-250 million ($0.36-$0.45 per share).
• We do not expect credit-related costs to be as large in Q4/08 as they were in Q3/08, as the collapse of a number of previously highly-rated U.S. financial institutions had a negative impact on SLF’s earnings ($636 million or $1.13 per share). In Q4/08, while we expect lower pressure on earnings from impairments, we expect continued reserve strengthening. Management stated in a late November investor day that the company’s bond portfolio had not experienced significant defaults in Q4/08 at that point.
• We expect year-over-year growth in the Value of New Business (VNB) to be muted, hindered by weak expected wealth management product sales given the state of equity markets globally, and by our expectation that insurance sales will be challenged by the weakness in global economies.
• We expect MFS to report 50% lower YoY net income in Q4/08, primarily due to weak equity markets. Operating margins are likely to continue to decline to 21%, from 32% in Q4/07 and 24% in Q3/08.
• We expect currency translation to only minimally positively impact Q4/08E earnings versus Q4/07, as reduced earnings in the U.S. largely temper the positive effect of a 19% average increase YoY in the U.S. dollar versus the Canadian dollar. In a more normal year, we estimate that a 10% decline in the Canadian dollar versus all other currencies would positively impact Sun Life’s earnings by 5%.
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Banks’ Efforts to Boost Capital Ratios

  
Scotia Capital, 14 January 2009

• Canadian banks in the past few months have raised $7.6 billion in capital, with 68% being common equity. The banks continue to issue modest amounts of preferred shares and Innovative Tier 1 capital.

• The Tier 1 ratio pro forma for the bank group is 9.8%, with the quality of the capital base relatively high, as preferred shares and Innovative Tier 1 represent 25% of total Tier 1, below the 40% maximum.

• We estimate the banks have capacity to issue a further $27.7 billion in non-equity Tier 1 capital, which would boost Tier 1 ratios by 250 basis points (bp) to 12.0%. The non equity capital component could be all qualified preferred shares or a combination, with Innovative Tier 1 capped at $4.7 billion or 15% of Tier 1. Although the banks have capacity from a regulatory perspective, it is highly unlikely the market would be able to absorb these amounts in the near term, especially preferred shares.

• The magnitude of capital raised since fiscal year-end represents 7.2% of Tier 1 capital, with the equity raised representing slightly less than 5% of the common equity base and 2.8% of market capitalization. The equity issues were readily absorbed by the market, but we believe they caused share prices to pull back approximately 10% as well as stall some positive share price momentum. The equity issues were at discounts to the market and at extremely low valuation levels with the market concluding that all banks would be coming to market at discount prices.

• The equity issues, we believe, were in response to market pressures, not regulatory pressure, as OSFI minimum Tier 1 ratio as stated is 7% with Canadian banks well above this level at 9.8%. It is highly likely that regulatory minimums will go up over the next several years; however, there is usually a phase-in period as there has been with virtually all Basel initiatives. Basel I capital standards were phased in between 1989 and 1992 with banks being given three years to achieve a minimum Tier 1 ratio of 4%. Required minimum total capital ratio was 7.25% in 1990, increasing to 8.00% by 1992, i.e., a 75 bp increase over two years. Canadian banks, we expect, will be able to easily exceed minimum capital requirements in normal course, even capital level requirements that are bound to overshoot prudence.

• The market pressure catalyst appears to be the capital infusions by U.S., U.K., and European countries to bail out their troubled banks and boost capital ratios. Despite the fact that Canadian banks’ capital ratio would still be above a number of the major global capital-assisted banks, with Canadian banks having less toxic assets and strong funding, the market fixated on a 10% Tier 1 as a minimum for Canadian banks. Also, global banks have yet to report their year-end numbers and the level of their capital ratios after potential further earnings, and retained earnings charges are still somewhat uncertain as well as the value of their high-risk assets. The bailout announcements were primarily in the last week of September and during the month of October 2008.

• In addition, OFSI released an advisory in October 2008 stating that “all financial institutions that have normal course issuer bids in place should not be repurchasing shares pursuant to those bids without first consulting OSFI,” which we believe added fuel to the fire and provided further impetus for the market to pressure banks to raise their capital ratios. The intent of the advisory was no doubt prudence but the results, we believe, played to investors’ fear about bank financial strength, especially given the psyche of the market.

• We believe the balance sheet or leverage problems in the global financial system have more to do with the nature and quality of the assets, both on balance sheet and off, as opposed to the amount of capital. There is no substitute for the prudent management of the asset side of the balance sheet, and when that fails dramatically (regulators? rating agencies? bank risk management?), it would seem virtually no amount of capital will be enough to sustain the company. In the earlier stages of a banking crisis, or maybe more appropriately put, brokerage crisis, it’s very easy to focus on the need for more capital versus the real adjustments that need to be made on the asset side. The amount of capital needed is thus proportionate to the magnitude of the problem assets/risk (on and off balance sheet).

• We continue to view Canadian banks as well capitalized even before the rush to raise capital, especially given the relative high quality of the asset side of the balance sheet, retail deposit base, and capital composition. We also believe banks can build their capital ratios up to the 11% range if they need to (we are in overreaction phase) on an orderly basis over the next several years through retained earnings, risk-weighted asset management, and issuance of preferred shares and Innovative at hopefully substantially lower costs. We expect retained earnings to add approximately 80 bp per annum to Tier 1 with earnings in dire straits still adding 40 bp.

• We do not believe banks should feel compelled to raise their Tier 1 ratio, especially in such a short time frame as it seems almost like panic, especially given the pricing. However, the counter argument we suppose is always prudence and perhaps the market will provide a higher valuation for the banks with higher capital ratios, at least in the short term. Clearly, all things being equal, 9% Tier 1 is better than 8% and 10% is better than 9%, etc. However, we simply don’t see the panic for Canadian banks to raise capital, especially equity, at these prices from a holistic perspective.

• All the banks except CIBC recently announced modest preferred share issues with yields creeping up to 6.25% (NA – 6.6%) from the 5%-5.5% level. BMO is the only bank to raise Innovative Tier 1 recently; however, BNS and TD have filed preliminary short form prospectuses. The yield on the 10-year BMO issue was 10.3%, with a possible range for BNS and TD if they decide to issue in the 10%-11% range, which is a hefty 600-700 bp over Canadas. It would seem that reset preferred shares at 6.25% that would likely be called after five years (recent resets: 400 bp over five-year Canadas) are less expensive capital than issuing 10-year Innovative at 10%-11% (6.5%-7.1% after tax – tax deductible) and common equity at 12%. However, we believe the preferred share market does not have the capacity to absorb nearly $28 billion in issuance.

• Interestingly, the major U.S. banks, Bank of America, JP Morgan, and Wells Fargo, each received US$25 billion in capital from the U.S. government with Citi receiving US$45 billion. Compare this to the entire Canadian banking system, which would require $27.7 billion to bring their capital ratios up to 12.0%.

• The U.S. capital infusion to these banks was in the form of non-voting preferred shares at 5% interest callable at par after three years, with the rate increasing to 9% after five years (major incentive to call). Compare this 5% financing in size with Canadian banks chipping away in the preferred share market with issues of $200 million-$300 million with the most recent coupon at 6.2%. However, the cost of government capital for a number of global banks has been extremely high in the 14%-22% range with perhaps some loss of autonomy.

• In our opinion, the fact that Canadian banks do not require government capital infusions and at the same time are maintaining arguably the strongest balance sheets globally is a testament to the strength of the Canadian banking system.
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BMO to Acquire AIG's Canadian Life Insurance Business

  
TD Securities, 14 January 2009

Event

BMO announced an all-cash deal to acquire AIG’s Canadian Life Insurance business.

Impact

Neutral. While not likely at the top of BMO's current strategic priorities, the bank moved on an opportunity presented by AIG to grow the bank's presence in insurance. Insurance is a potential growth area for the industry and to us, it makes sense for BMO to be there. The transaction should add some manufacturing and distribution expertise to BMO's efforts to develop its insurance offering. However, managing risk and return over very long dated assets is critical in this space and bears watching as the bank enters the arena. A relatively small transaction, we have made no changes to our outlook.

Details

Adds range of business lines. The bank has not disclosed details around the book of business that will come with the transaction (regulatory filings indicate AIG Life Insurance Company of Canada has assets on the order of C$2.4 billion as of Q3/08), but the platform offers a range of life products (Term, Whole, Universal), critical illness coverage and segregated funds. Filings also indicate the entity was comfortably reserved with MCCSR at 205%.

Bank developing its insurance presence. BMO has previously focused largely on the familiar turf of credit insurance and acted solely as a sales channel through its wealth and private banking businesses for a wider range of insurance products. With this transaction the bank is now in the business of managing assets and will be increasingly focused on product development and manufacturing.

Managing risk and returns is critical. The life, annuity and illness businesses requires considerable expertise and due diligence to effectively manage the risk and return profile of what are often extremely long dated assets. BMO has some in-house personnel and this transaction should bring with it additional experience and expertise. We expect the bank to move in manageable steps (as it has with this transaction), however, to us it will be critical to monitor developments in the business line over the coming years.

No changes to our outlook. In the context of the bank this is a relatively small transaction and we have not made any changes to our outlook, although the bank expects the deal to be accretive to cash EPS in year 1 (not quantified).

Transaction Details

All cash deal. The deal is valued at C$375 million or approximately 1.06x book. The deal is expected to close by June 1, 2009.

Accretion. The deal is expected to be accretive to earnings in year 1, although no guidance was provided. Insurance accounts for approximately 2% of BMO’s total core revenue base in fiscal 2008, or about C$50 million per quarter. By our estimates, we could see insurance generate less than C$25 million in net income per year. As per Office of the Superintendent of Financial Institutions (OFSI) regulatory financial statements, AIG Life Insurance Company of Canada generated approximately C$55 million in net income over the past four reported quarters ending Q3/08. The earnings impact from the acquisition will unlikely be material to BMO’s overall net income.

Capital. BMO has indicated the Tier 1 capital impact from the transaction will be less than 15bps. Based on our estimates, BMO’s Tier 1 capital before the deal (pro-forma capital raises post Q4/08 reported Tier 1 of 9.77%) is approximately 10.5%.

Outlook

We have made no changes to our estimates or Target Price.

Justification of Target Price

Our Target Price reflects a discount to our estimate of equity fair value 12 months forward (based on our views regarding sustainable ROE, growth and cost of equity), implying a P/BV of 1.25x.

Key Risks to Target Price

1) Additional losses or write-downs from key risk exposures 2) significant competition in the Chicagoland market and 3) adverse changes in the credit markets, interest rates, economic growth or the competitive landscape.

Investment Conclusion

The bank moved on an opportunity presented by AIG to grow the bank's presence in insurance which is a potential growth area for the industry and in our view, it makes sense for BMO to be there. The deal is a relatively small transaction and we have made no changes to our outlook.
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Financial Post, Jonathan Ratner, 13 January 2009

Calling Bank of Montreal’s $375-million cash purchase of AIG’s Canadian insurance business “a bit of a steal,” Dundee Securities analyst John Aiken highlighted the fact that management’s calculated price to book was under 1.1 times. That compares to an average price to book multiple of 1.3x for Canada’s four publicly traded insurers.

More importantly given the current environment, however, is the fact that the acquisition of AIG Life of Canada will only have a modest impact on BMO’s capital ratios, Mr. Aiken told clients. The bank’s management anticipates a less than 15 point decline in its Tier 1 ratio.
On a pro forma basis including recent capital issues and changes in risk-weighted assets, the analyst said BMO’s Tier 1 capital is above 10.2%, “still above the market’s apparently mandated 10% minimum threshold.”

“We view the acquisition favourably as it will benefit BMO by diversifying its revenues, gaining access to additional customers and add to earnings,” Mr. Aiken said. “However, this is not a transformational acquisition but does put the bank in good stead if the Canadian Bankers Association can lift the restriction of branch sales of insurance at some future point.”

Nor does it change the analyst’s position on BMO, which he said has been leading the charge in credit deterioration among the Big 6 banks so far in the current downtrun. So while this deal may help explain why BMO issued common equity in December, Mr. Aiken said it still does not justify the bank issuing shares below book value. He continues to rate BMO at “neutral” with a $28 price target.

Desjardins Securities analyst Michael Goldberg notes that bank investments in insurance subsidiaries are not consolidated under Basel II rules. However, those rules will change in 2011 when 50% of an investment would be deducted from Tier 1 capital, which he said would produce a further 10 basis point reduction.

“BMO’s intent is to become a one-stop shop for its clients, allowing it to expand its insurance and wealth management offerings,” Mr. Goldberg said in a research note.

He views the acquisition as immaterial to near-term earnings but positive for optics. “For BMO, optics are relatively more important as its uncertain outlook is reflected in the stock’s 8.5% yield,” the analyst said. Nonetheless, he thinks the near-term impact will be positive, as optics should outweigh the small near-term fundamental impact. Mr. Goldberg rates BMO at “hold” with a $44.50 price target.

He also believes that markdowns and the losses incurred aside, earnings in the Canadian banks are prolific. “The question remains: how large are the holes that are to be filled.”

RBC Capital Markets analyst Andre-Philippe Hardy noted that AIG’s life insurance business is small with earnings of $48-million in 2009 and a loss of $17-million in the last 12 months. This compared to BMO’s annual earnings of more than $2-billion.

“AIG’s range of individual life and annuity products allows BMO to broaden its range of insurance products, which has primarily been credit life and disability insurance, but the small scale will not have a large impact on the growth outlook,” he told clients.

Since Canadian banks cannot sell life insurance in their branches nor share databases with their life insurance subsidiaries, revenue synergies will be limited, Mr. Hardy said. However, BMO intends to offer insurance products as an extention of existing wealth management offering and can sell through its brokerage channel, he added.

RBC maintained its “underperform” rating on BMO. It views the bank’s stronger capital position positively but believes the banks has more exposure to “potentially problematic off-balance sheet assets” and to U.S. lending.
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Friday, January 09, 2009

RBC CM Bank CEO Conference

  
RBC Capital Markets, 9 January 2009

5 Canadian Bank CEOs and BNS' Head of Canadian Banking participated in our annual RBC Capital Markets Bank CEO conference yesterday.

Common themes

• Banks are targeting higher capital levels than in the past, and we feel will continue to raise capital (mainly non-common equity). There was a common desire to not rely on Government support in capital raising efforts.

• The tone on credit quality was more negative/cautious than a few months ago. The banks continue to watch for losses in commercial and credit card portfolios rather than Canadian mortgage books, and lower single name exposures and other structural/economic differences better position the banks relative to the early 1990s recession.

• Business loan growth remains robust as reintermediation from non-bank/non-domestic lending alternatives offset tighter credit standards. There were mixed messages on current retail loan growth, with some banks mentioning a pull back in consumer borrowing, while others were more positive.

• Margins should benefit from asset repricing on the wholesale side and a higher Prime/BA spread on the retail side. However, this will likely be partially offset by higher wholesale funding costs and competitive retail deposit pricing.

• The banks with U.S. banking operations did not appear keen to make major acquisitions in the near term.

• Industry regulation will likely increase but the Canadian banks have not received Government capital, and should be less impacted than many global peers.

Thesis unchanged

We continue to believe that it is too early to buy Canadian banks based on: (1) an economic environment that continues to deteriorate rapidly, (2) pressure on bank capital ratios (which are high relative to regulatory targets), (3) our belief that the street needs to lower its profitability estimates (our EPS estimates are currently 7% below the street's) to reflect the rapidly slowing economy and credit/funding markets that remain challenged, and (4) valuations that have declined but are not that low relative to prior recessions.

For greater detail on our views for the industry, please see our December 10 report titled Still Too Early to Buy and our December 24 update on the banks' capital positions.
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Reuters, Frank Pingue, 8 January 2009

Canadian banks say the time is not right to rush into large acquisitions in the United States or abroad, even though the global economic downturn has made banking assets look like relative bargains.

Royal Bank of Canada, the country's biggest bank, Toronto-Dominion Bank, the No. 2, and Bank of Montreal, the No. 4, said on Thursday they will be cautious and patient when it comes to making any major deals, but will watch for small acquisitions that complement their businesses.

They said the economic climate that has tightened credit conditions means now is not the time to unload large amounts of cash on a big purchase.

Royal Bank said it will continue to look for opportunities in areas that will add to its established businesses but it does not anticipate any blockbuster deals.

"We're looking at opportunities as a result of the turmoil to add to our existing franchises in a sensible way where we can take advantage of them," Royal Bank President and Chief Executive Gordon Nixon said at an investor conference in Toronto.

"But in terms of significant dramatic transformational acquisitions, whether it be the U.S., Europe or Asia, we just don't believe in this environment that it's the appropriate time to be aggressively deploying capital."

BMO Financial Group President and Chief Executive Bill Downe said taking on another bank's loan book and having to work it out is not a very attractive proposition.

"We've been very cautious in the last 18 months with respect to making acquisitions in the U.S. and I still think it's early ... I think you can be quite patient," Downe said.

TD Bank President and Chief Executive Ed Clark said he does not have "enough visibility" on asset risk in the United States to determine whether to make a deal.

Clark also said he does not expect that to change during the first half of 2009 unless he gets a clearer sense of when the economic downturn will bottom out.

TD Bank said all of Canada's banks are going through their loans to determine whether they are being prudent enough when it comes to lending, but he was quick to add that does not mean they are tightening credit.

"What we are not going to do, though, is turn down people who we think could repay us," Clark said.

"I do want to take advantage of this and take market share. I mean, this is a one-time opportunity to change the game and why wouldn't I do that if I could do it prudently."

RBC's Nixon added that to a large degree it is "business as usual" even though credit in some sectors, namely the automotive sector, has become much tighter.

Nixon said RBC continues to see growth across most of its business, including residential mortgages, home equity loans, credit cards and small business lending.

"We're trying to manage it from a risk perspective in a prudent fashion, but we are continuing to see business growth across most of those lines," he said.
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Manulife Says News Report of Accounting Probe is False

  
Scotia Capital, 9 January 2009

• The National Post recently ran a story alleging MFC is facing an accounting probe by the Attorney General of Indiana into the tax treatment of a supposed leveraged lease arrangement with an Indiana non-profit electricity cooperative (Hoosier Energy Rural Electric Cooperative). MFC says reports of an accounting probe are false.

What It Means

• The story falsely (per MFC) alleges an investigation stems around a $120 million tax benefit to MFC ($0.07 EPS) because of a slip in credit rating of one of the parties to the complex tax deal agreed in 2002.

• MFC is an investor in leveraged leases. In the U.S. several recent court cases related to their tax treatment have been concluded in favour of the tax authorities. In recent quarterly reports MFC claims it believes the deductions originally claimed in relation to its investment in leveraged leases are appropriate, but increased its provision for disallowance by US$33 million ($0.02 EPS) in Q2/08 to US$178 million ($0.13 EPS). MFC further disclosed that, although not expected to occur, should the tax attributes of its leveraged lease investments be fully denied, its maximum tax exposure would be US$387 ($0.28 EPS)
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Financial Post, Eoin Callan, 8 January 2009

Manulife Financial Corp. has sought an expedited ruling from a U. S. court over a financial dispute with an electricity co-operative in Indiana, in a move that may help the insurer draw a line under a complex case that has attracted political heat.

Canada's largest insurer is thought to be seeking a ruling within as little as 30 days from an appeal court weighing whether Manulife is owed US$120-million arising from the collapse of a tax deal with the utility.

The dispute was triggered at the height of the crisis in the banking system, when trust between financial institutions was at a historic low. But there were tentative indications yesterday that a resolution might be nearing, with people close to both sides not ruling out an out-of-court settlement.

A settlement could potentially cool the interest in the case by U. S. authorities such as the Office of the Indiana Attorney General, particularly if it is seen as having little affect on customers of the utility in the midwestern state. The state's chief legal enforcement office began making formal enquiries last month after the financial dispute escalated, according to people familiar with the matter.

Manulife said yesterday a report in Wednesday's Financial Post "that state regulators in the U. S. were investigating accounting practices regarding investments made by the company's U. S. division was completely erroneous."

The company said in a statement that, "it has not been advised by any regulators -- and has no reason to believe-- that any of its accounting practices are being investigated."

People familiar with the matter said the insurer had received inquiries from the Office of the Indiana Attorney General on Dec. 12. A spokesperson for Manulife yesterday declined to provide a copy of the correspondence, saying it related to a matter that was being treated as "confidential."

People close to the company said they did not view any requests for information the company may have received from the Office of the Indiana Attorney General as constituting a probe of its accounting practices.

The company is thought to have co-operated with the request and supplied documentation to the attorney general's office related to a complex tax transaction between Manulife's U. S. subsidiary, John Hancock, and Hoosier Energy Rural Electric Cooperative.

The transaction was cited last month in the U. S. Senate as an example of a type of tax deal entered into by many financial institutions that leading lawmakers and federal authorities have been working to shut down. A dispute between the two companies was triggered when the financial crisis caused a slip in the credit rating of Ambac, one of the parties providing insurance against default on the deal.

Manulife yesterday supplied the Financial Post with highlighted excerpts of affidavits and court submissions that reflect its view of the transaction.

"There is nothing nefarious or commercially unusual about these financial arrangements and, in all events, they were of Hoosier's doing," the documents stated.

"Hoosier and its advisors, not Hancock, structured the transaction and Hoosier and Hancock negotiated the contracts and closed the transaction at issue here in the State of New York," the documents said.

The court submission states: "Hancock demanded payment from AMBAC because AMBAC's credit ratings dropped below the minimum level of creditworthiness specifically negotiated by the parties and Hoosier has been unwilling (or unable) to replace AMBAC with an adequate alternative. All agree that Hancock has scrupulously adhered to the procedures provided for in the contracts. The problem is that Hoosier no longer wants to live up to its contractual commitments.")
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Financial Post, Eoin Callan, 6 January 2009

Manulife Financial Corp. is facing a probe of its accounting practices by U.S. state enforcement officials in connection with the insurer's role in a controversial tax shelter that has collapsed amid the credit crisis, according to people familiar with the situation.

The Attorney General of Indiana and authorities from other American states where the Canadian insurer operates have contacted the company seeking greater disclosure about how it is treating questionable tax schemes on its books, these people said.

The probe by the chief legal enforcer for the midwestern state underlines how the economic fallout from the credit crisis is bringing the practices of financial institutions under scrutiny, and creating a potential quagmire for Manulife.

Indiana initiated its probe after a recent move by Manulife that would force a non-profit electricity cooperative in the state into bankruptcy by claiming a $120-million payment on a complex financial transaction constructed around an elaborate tax-avoidance structure viewed by authorities as abusive.

While the windfall would provide Manulife with a cash injection at a time when its U.S. subsidiary is draining capital from the parent company because of heavy exposures to volatile financial markets, the claim risks releasing a protracted regulatory backlash against the insurer.

The fresh state-level probe is understood to be aimed at getting a better understanding why Manulife's U.S. subsidiary, John Hancock, has been unable to reach a settlement with the Indiana utility, the Hoosier Energy Rural Electric Cooperative, which serves about 350,000 customers in the American corn belt.

Enforcement officials are thought to be seeking insight into whether the impasse is in any way being aggravated by the pressure on the capital reserves of insurance companies and the way in which they treat tax items on their books.

The financial claim is currently before the courts and has drawn the ire of U.S. lawmakers who regard the underlying tax structure as a sham. It has also spurred action by local authorities who fear consumers will be hurt by the fallout.

In a letter seen by the Financial Post that was sent to Senate Majority Leader Harry Reid and House Speaker Nancy Pelosi, a senior member of the U.S. Congress warned that "foreign corporations" were exploiting the credit crisis to deprive the government of tax dollars and force vital utilities into distress.

Manulife is in a position to claim the $120-million because of a slip in the credit rating of one of the parties to the complex tax deal agreed in 2002. This would allow the Toronto insurer to reap the full benefits of the deal -- set up to transfer tax benefits -- before the U.S. Internal Revenue Service steps in.

But the chances of Manulife ultimately succeeding in recovering the funds is looking increasingly slim.

Congressional aides have told the Financial Post that leading Senators are currently drawing up a law that would create a punitive excise tax of up to 120% on any money recovered by Manulife and other financial companies engaged in similar efforts to shut down tax deals with non-profit utilities early.

Manulife said the chairman of its audit committee, Richard DeWolfe, was unavailable to discuss the matter, while John Hancock declined to comment.

The company's independent auditor, Ernst & Young, did not respond to requests for an interview.
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Wednesday, January 07, 2009

Another Round of Favourable MCCSR Changes from OSFI for Insurance Cos

  
Scotia Capital, 7 January 2009

• Over the Christmas holidays OSFI announced a series of changes to capital rules, with two important changes for 2008 year-end. We estimate the changes will boost the MCCSR ratios of GWO, MFC, and SLF by up to 8-11 percentage points. IAG has already announced the changes would boost its MCCSR by 14 percentage points. The two key changes for 2008 year-end are as follows:

1. Net unrealized gains/losses on available for sale (AFS) debt securities no longer impact Available Capital. Previously, net unrealized gains were added and net unrealized losses were deducted. AFS investments primarily back a life insurer’s surplus, with the bulk of the assets, categorized as “held for trading,” backing policy liabilities. OSFI’s decision to eliminate the impact of unrealized gains and losses on AFS debt securities is in keeping with the same theme in its previous announced changes (end of October on segregated fund reserving), where it attempts to mitigate the sensitivity of the MCCSR to volatile swings in the market. As well, AFS securities are generally held to maturity, so swings in market value should not significantly impact available capital.

2. Elimination of the interest margin pricing risk component, often referred to as the C-2 component. This component, representing 1% of recurring premium paying (generally individual life insurance) policy liabilities supposedly represented the risk associated with interest margin losses associated with future investment and pricing decisions on in-force business. It overlapped significantly with the C-3 component (changes in interest rate risk) and was thus eliminated. Lifecos with proportionally high amounts of in-force individual life insurance business relative to the rest of their business (like IAG) stand to benefit the most from the elimination of the C-2 component.

• Changes add even more capital to already very well capitalized companies. We outline the impact in Exhibit 1, along with the Q4/08 estimated MCCSR ratios, estimated excess capital positions, and sensitivity of the ratios to 25% changes in equity markets. All the companies are extremely well capitalized, with MCCSR ratios above 200% at December 31, 2008 (our estimates are GWO at 234%, IAG at 203%, MFC at 243%, and SLF at 237%). In less volatile markets one might assume anything above 200% is excess capital. Using this metric, surprisingly enough, we estimate excess capital levels to be fairly close to the amounts raised in Q4/08, or, in the case of SLF, raised by means of the sale of CIX. The recent raisings do provide significant buffer, though. Should markets fall 25% from December 31, 2008 levels (i.e., the S&P 500 falls to 677 and the S&P/TSX falls to 6,740), all the lifecos will have MCCSR ratios well within their target ranges. Should markets continue to rebound, we would anticipate the increasing amount of excess capital would be put to work, likely by way of acquisitions (in the case for all the companies), as well as debt repayment (MFC would likely pay off its $2 billion loan).
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Financial Post, Jonathan Ratner, 5 January 2009

Sun Life Financial Inc. lost roughly 45% of its value in 2008, taking the stock from above $50 per share early in the year to under $30. Citigroup analyst Colin Devine doesn’t think prospects will improve much for investors in 2009, cutting his price target on the life insurer from $40 to $30 and trimming his earnings estimates for 2008 through 2010.

The changes reflect the impact of the fourth quarter equity market decline on fee-based revenues tied to lower segregated and mutual fund assets under management. They are also a result of higher variable annuity reserving and hedge-related costs, as well as the impact of the weaker Canadian dollar, Mr. Devine told clients.

Since Sun Life’s variable annuity (VA) risk management practices in the U.S. have been far more disciplined that those of arch rival Manulife Financial Corp., it is not expected to need a massive increase in VA reserves due to equity market declines that would prompt an equity capital raise, the analyst said.

At the same time, Mr. Devine said Sun Life’s solid balance sheet, upgraded U.S. management team and significant cash position following the sale of its 37% stake in CI Financial Income Fund to Bank of Nova Scotia, puts it in a very good position to take advantage of weakened competitors.

“M&A represents potential valuation catalyst that could lead to upgrade in our rating,” he said, adding that targets could include Lincoln National Corp., Principal Financial Group Inc., Aegon NV, Ameriprse Financial Inc. or Hartford Financial Services Group Inc.

In terms of Sun Life’s fourth quarter results for 2008, the Citigroup analyst expects equity markets will drive down earnings per share by 40.5% to 58¢. However, this should be offset be an approximate $1.25 per share gain from the CI sale.

Mr. Devine said on a relative basis versus its peers, Sun Life’s whole continues to be less than the sum-of-the-parts. “Getting to the next level will require major gains by the underachieving U.S. operations, the market that offers the greatest potential, as we see it, to boost EPS. We believe recent management changes were an important first step, but will need to be followed by significant M&A.”
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The Globe and Mail, Tara Perkins, 5 December 2008

Sitting in his Toronto office on Bloor Street, overlooking the treetops of the Rosedale ravine, Dominic D'Alessandro picked up the phone and, one by one, placed direct calls to the chief executives of each of the nation's biggest banks.

It was a Friday in late October, and the chief executive of Manulife Financial Corp. needed help. North America's biggest life insurer was recalculating its capital ratios every day, and plunging stock markets were dragging them down. Mr. D'Alessandro realized his company – the one he had personally turned into a global giant – would soon be forced to sock away billions of dollars to shore itself up. He couldn't get by without the big banks that he had so often criticized.

In the previous few days, Mr. D'Alessandro had been working another angle, trying to persuade Julie Dickson, who heads the country's banking and insurance regulator, to change the rules that were requiring Manulife to set aside massive amounts of money for every downtick in the stock market.

Mr. D'Alessandro laid out his case for her. The capital rules are too onerous, he said. They oblige Manulife to build a huge financial cushion, enough to carry it through a catastrophic event and a scenario where markets don't recover for a decade. But that cushion was straining the company's finances, he argued. It didn't make sense. If stock markets recovered, the cushion would become unnecessary.

For someone like Mr. D'Alessandro, who is known for calling the shots rather than dodging them, it was an unusual position. This is the same man who graduated from high school at age 14, ran a bank by age 41, and was the architect of a dramatic ascension that had made him a living legend in Canadian financial circles. The company's funds under management have more than tripled since 1999, when Mr. D'Alessandro took the firm public, to $385.3-billion, and it now has more than 24,000 employees serving customers in 19 countries and territories.

“Of course I would have preferred a little less adventure and a little less challenge in my final months with the company. Of course,” he says, referring to his planned retirement next spring.

“I don't think I'm alone in saying I didn't foresee an event of this severity. I love it when people say ‘why didn't your forecast it? Aren't you paid to know these things?' Well, I know a lot of things, but I didn't know that.”

The fall of 2008 is now littered with stories of how American and European financial giants were brought to their knees. Canadian politicians crowed about how safe Bay Street seemed by comparison. But for a few tense weeks in October, the dramatic turns inside Manulife showed how vulnerable Canada's most trusted institutions are to the turns of a global market.

As Mr. D'Alessandro made those calls to bank CEOs – and his company's stock plunged from near $35 at Thanksgiving to $24 around Halloween – he was pushing to make sure Manulife was not one of the victims. But he was also on a personal mission – to preserve his own legacy and reputation, with the clock ticking as his 14 years at the helm wind down to an early retirement in May. The plan wasn't just to guide his company through the credit storm, but to put it in a position of strength, to be one of the players expanding while others reeled. Otherwise he risked going out under a cloud.

The rapid collapse of Manulife's good fortunes is easily predictable with hindsight.

The company's beginnings date back to 1887, when an Act of Parliament incorporated The Manufacturers Life Insurance Company and the country's first prime minister, Sir John A. Macdonald, was elected president.

Mr. D'Alessandro took the helm 107 years later. The son of Italian immigrants, he arrived in the country at the age of three and would go on to build a career as a master of the takeover, beginning at Laurentian Bank and later at Manulife. In 2000, six years after Mr. D'Alessandro took over, the firm became the first Canadian life insurer to earn more than $1-billion in one year.

But it wasn't until the $15-billion merger with U.S. life insurer John Hancock Financial Services Inc. in 2004 that Mr. D'Alessandro really succeeded in muscling Manulife onto the global map. That deal made it the fifth-largest life insurer in the world, and raised expectations that Mr. D'Alessandro would deliver a financial performance to take on the biggest and the best.

“At the start of this year, they were one of the, if not the, strongest life insurers globally,” says Peter Routledge, vice-president and senior credit officer at Moody's Investors Service.

Mr. D'Alessandro's aggressiveness is at odds with the stereotype of the staid insurance man, but it successfully took the company from the era of traditional conservative insurance into the modern arena. In May he will hand over the corner office to his successor, chief investment officer Don Guloien, a man 10 years his junior who has spent the past 28 years at Manulife and at one point was head of mergers and acquisitions.

A lot of Manulife's specific problems today were compounded by a decision that Mr. D'Alessandro and his colleagues made in 2004 to remove the hedging on the equity positions it held in its variable annuity business. For several years, that decision boosted Manulife's profits. Then it backfired.

Variable annuities (also known as segregated funds in Canada) have been around since the 1980s, but caught on fire in recent years. They can be thought of as something akin to a personal private pension plan for an individual. A customer gives money to Manulife, and the insurer invests it, often in mutual funds or indexes with a small proportion in bonds. Manulife promises the customer payments down the road, generally after retirement, and guarantees benefits in return for a fee.

One key aspect of the variable annuities and segregated funds business is they give the company significant exposure to stock markets. When the insurer's stock portfolio sinks, so do its capital ratios, which are determined by a complex set of rules that dictate the amount of money the firm must have on hand to reasonably ensure it will be able to make the payouts that customers might claim down the line.

Here's how they work, courtesy of a company sales brochure designed for its brokers. Bob, age 65, has $500,000 in retirement savings and needs to take income immediately. He invests $500,000 with Manulife, and establishes an annual guaranteed income of $25,000. Lets say the value of his $500,000 market portfolio drops to zero in 16 years. Bob still receives $25,000 from Manulife for the rest of his life. If markets perform well, his annual payments could one day be nearly double that amount.

Variable annuity investors can make money when markets rise, but also have some protection when they drop, depending on the guarantee they've bought. Financial advisers often pitch the products to people between the ages of 50 and 70.

Michael Morrow, a certified financial planner in Thunder Bay, Ont., started recommending Manulife's IncomePlus products at the beginning of this year. “What made it attractive for customers was I could tell them that if they started to take an income out the year they turned 65, they were guaranteed that income for the rest of their life, and that was the worst-case scenario,” he says. “What you're doing is you're buying a life jacket or you're buying a seatbelt.”

Bill and Marianne McDougall, retired teachers in New Liskeard, Ont., are among customers who saw the appeal. The biggest selling point “was the fact that in a downturn we still had that guaranteed income,” Mr. McDougall says.

Variable annuities have been all the more appealing to companies such as Manulife because life insurance sales have by and large been stagnant for decades. Life insurance reached its peak after the Second World War, when soldiers returned home with a strong sense of their own mortality and worried about providing for their families. But in the 1970s, more women went to work, divorce rates rose and that sense of mortality diminished, causing a slowdown in sales.

Between 2002 and 2007, life insurance sales grew 3 per cent a year in Canada and 6 per cent in the U.S., according to RBC Dominion Securities analyst André-Philippe Hardy. During that same period, the Canadian and American variable annuity markets grew 13 to 14 per cent annually.

For its part, Manulife boasts that it “turned retirement thinking on its head” in Canada in October of 2006 with the launch of the country's first guaranteed minimum withdrawal benefit product, GIF Select featuring IncomePlus. The insurer launched a massive advertising campaign and in Mr. D'Alessandro's 2007 letter to shareholders, he lauded the company's “flourishing” and expanding business.

Manulife's U.S. variable annuity sales topped $10.8-billion (U.S.) that year, up 18 per cent. The company was one of the top 10 players in the U.S., and the No. 1 player in Canada.

But back in 2004, Manulife's executives stopped paying for reinsurance against the stocks backing its annuities and opted to take the risk of a market drop itself instead. Manulife was an insurer, it should be insuring itself, they thought.

It is a move that UBS Securities analysts now label “imprudent,” but for years Manulife's executives stuck to the decision. In early 2007, they started to get a bit nervous when the business was growing by leaps and bounds. Manulife was stealing market share in the U.S., and had introduced products in Japan and Canada. Its exposure to stock markets was ballooning as a result.

Manulife decided, belatedly, to develop its own program internally, and slowly started rolling it out in November of 2007, three months after the credit crunch first erupted. It continued to move slowly, and as the financial crisis rippled through the markets it became more expensive to put the hedges in place.

Nearly one year on, the program covers about $3-billion of Manulife's U.S. variable annuity account value. The company believes the program protects it from more than 80 per cent of the losses that substantial market declines could cause in the hedged part of its portfolio, and it plans to hedge its new business from now on. But the damage has been done.

The key measure of an insurer's financial cushion that OSFI keeps an eye on is called the minimum continuing capital and surplus requirements (or MCCSR) ratio. It's a complicated test of whether the insurer's assets are sufficient to cover its liabilities. It measures the minimum capital and surplus the company needs, adjusted for how risky its business and investments are. Insurers must keep the ratio above 150 per cent, and Manulife tries to keep its ratio between 180 and 200 per cent.

In the first three months of the year, it dipped 23 percentage points, prompting Manulife's executives to decrease share buybacks and take other action to boost capital, bringing the ratio back up to 200 per cent. But the implosion of Lehman Brothers in September and subsequent near-collapse of AIG, once the world's biggest insurer, sent markets into an extended spiral that would whack Manulife once again.

On Sept. 16, the U.S. government announced a bailout of AIG, which planned to sell off pieces of itself to pay the government back. Manulife's executives wasted no time jumping on potential opportunities to grow their company. For Mr. D'Alessandro, this was the chance to pull off one final blockbuster deal before he retired. For Mr. Guloien, it was a chance to push the company he will soon run firmly to the front of the pack. On Sept. 22, Mr. Guloien was meeting with investment bankers in Toronto to talk about putting together a bid for some prized pieces of AIG. But stock markets continued to move at speeds that took investors breath away, and the crisis was turning financial institutions around the globe into punching bags.

By the end of September, the value of the funds that Manulife had invested in equities and bonds for segregated fund and variable annuity customers stood at $72.74-billion. That was $12.85-billion short of the amount the company had guaranteed to pay out down the road. (Most of the payments Manulife has promised customers come due between seven and 30 years from now.) In no time, potential acquisitions were on the backburner. Manulife's top team had more pressing issues to deal with.

There were rumours that Manulife might issue a large amount of stock in order to raise capital, diluting its current shareholders. Mr. D'Alessandro decided to hold a conference call with analysts on Oct. 14 to put those fears to rest. “When you see your stock drop by 25 per cent in two days, it sort of focuses your mind that maybe you ought to pay attention to reassuring, and making your investors understand your position,” he told them. “We think that Manulife was sideswiped by the meltdown in the markets in a way that grossly exaggerates any impact that they're going to have on us.”

The company had no intention of issuing equity to raise capital, he said. If it came to it, Manulife would think about issuing preferred shares or debentures to boost capital levels. Within days, Mr. D'Alessandro was lobbying Ms. Dickson to revise regulatory guidelines on capital and she was persuaded by his argument. On Oct. 28, OSFI announced that it was changing the rules to give insurers a break on the amount of capital they had to set aside for payments that were more than five years away. The changes brought Manulife's capital ratio closer to 200 per cent, but executives decided they needed more of a buffer in case markets continued to tumble. That weekend, the company negotiated the final details of a $3-billion loan from the country's six largest banks.

Those two measures collectively brought the insurer's capital ratio up to about 225 per cent, but only temporarily. They did not take the heat off of Mr. D'Alessandro and his colleagues.

In the first week of November, Prime Minister Stephen Harper requested a meeting with a handful of top executives from the country's financial institutions in order to gather their thoughts ahead of a meeting of G20 leaders in Washington the following week. But on the Thursday afternoon, when some of his peers were giving the Prime Minister their thoughts, Mr. D'Alessandro was instead taking a grilling from analysts. Manulife had just revealed that its third-quarter profit had fallen in half from a year ago, to $510-million, because the steep drop in stock markets shaved $574-million from its bottom line.

Citibank analyst Colin Devine laid into executives on a conference call that afternoon, questioning Manulife's risk management systems. Over the years, Manulife chief financial officer Peter Rubenovitch had told analysts many times that he would be comfortable dealing with a 10- to 15-per-cent drop in markets, and that's why the company didn't have a hedging program. But this drop was steeper than that.

“Why was some sort of pro-active action not being taken in October while all of this was going on, because what would you have done if OSFI effectively hadn't moved the goalpost for you?” Mr. Devine demanded. “Because it seems [to me] you might have had to raise $5-billion of equity.”

Mr. D'Alessandro stepped up. “You're entitled to your view, Colin, that it was a breakdown,” he said. “In one week we had a massive reorganization of the financial sector. Maybe you guys saw it at Citibank, but we didn't see it.”

In the weeks to follow, Manulife's capital ratio softened yet again, landing somewhere around 200 per cent. “The world has completely changed,” Genuity Capital Markets analyst Mario Mendonca said. Over the course of October and November, stock indexes dropped a further 21 per cent in Canada, 23 per cent in the U.S. and 24 per cent in Japan.

Analysts pressed the firm to raise equity and suggested that issuing $3-billion worth of shares would give the insurer enough capital to meet challenges as well as jump on opportunities in 2009, if the company hadn't lost its reputation as an attractive suitor. With the pressure rising, Mr. D'Alessandro finally softened to the idea of issuing equity. On Nov. 26, the company began canvassing the market. This past Monday night, executives decided to proceed with a plan to issue at least $2.125-billion of common equity. At the same time, Manulife paid back $1-billion of its bank loan that it no longer needed.

Manulife is now looking at a $1.5-billion loss for the final three months of the year, the first time it has dipped into the red since going public in 1999. Mr. D'Alessandro acknowledges that his decision to issue equity is an about-face. But circumstances have changed dramatically since October, when he said the insurer would do no such thing. “It was what I believed when I said it, and had the market been more receptive to our solution, it might have prevailed,” he said in an interview this week.

Shareholders were increasingly encouraging him to put the problem behind the company, he said, something he had hoped to accomplish with the bank loan. “So we bit the bullet.”

While Manulife's capital ratio was still within its target prior to the equity issuance, the company's old targets aren't good enough for the market any more. “We were still comfortable, but it didn't give us any latitude,” said Mr. D'Alessandro, who believes that OSFI's capital rules are still too strict, even after the changes.

“I don't think that Dominic would have wanted to go out like this,” said Shane Jones, managing director of Canadian equities at Scotia Cassels. “It's tarnished his reputation.” But he quickly adds that, in fairness, “the decline in the market took us all by surprise.”

“I felt pretty good that this stuff had been dealt with, but then the markets kept going down and down and down,” Mr. D'Alessandro says. “I don't see it as a failing on my part. What could I have done?”

Moody's Mr. Routledge says the equity raise doesn't make any material improvement to Manulife's financial flexibility in the near term, or compensate for lower earnings going forward. “It helps, it just wasn't enough,” he said. Nearly all of the new equity will be eaten up by the fourth-quarter loss and dividend payments. Over the course of the year, “they went from being excellent to just great,” he said.

Joseph Iannicelli, chief executive of the Standard Life Assurance Company of Canada, believes this is a short-term blow for Manulife. Of his rival Mr. D'Alessandro, he says “the timing is unfortunate because it is at the tail end of his career with Manulife.”

Manulife expects to have $5-billion in reserves for its variable annuity guarantees at the end of this year, up from $526-million at the beginning. If markets recover, which they presumably will, it will be able to release its reserves back into earnings, and put some of its headaches behind it.

Mr. D'Alessandro still deserves a tremendous amount of respect for what he has accomplished in his career, Mr. Iannicelli said. “He took a Canadian company global, and kind of put the Canadian insurance industry on the map,” he said. “The acquisition strategy has been brilliant. Each deal was either more complicated or more bold or bigger.”

Pieces of AIG are still up for grabs, and a number of U.S. life insurers are now ripe for takeover because their stocks have taken a pounding. The opportunities are tremendous. Mr. D'Alessandro has not lost his appetite to swallow one last target. The question is will he be able to now?
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Banks Respond to Rising Capital Demands

  
TD Securities, 7 January 2009

Group responds to rising capital demands. There has been a flurry of capital raising activities across a number of the Canadian banks over the past few weeks. We thought it would be useful to see where the industry stands pro-forma these events. We have included our Capital Table for the eight companies in our coverage universe (Exhibit 1).

More than one metric. We do not subscribe to a single hard and fast measure of capital adequacy and we prefer a more holistic approach. Regulators are focused on issues of solvency, equity investors pay close attention to measures of book value and equity returns while management must strive to balance both. We have provided six of the more common metrics that include both risk based and nominal balance sheet measures.

Not all banks are equal. Likewise, bank platforms differ in material respects and we do not believe in applying a single universal target level for any metric. Certainly risk based approaches attempt to reflect variances in business mix/risk, however, they are at best imperfect measures and are limited in so far as they are largely point estimates focused on the balance sheet. In our mind, a platform's ability to generate significant and steady earnings over time that can replenish capital is an important consideration in assessing what level of capital may be deemed appropriate.

Credit and Capital are linked. Finally, we believe the capital discussion is incomplete without taking into account a bank's credit position; particularly as we enter a significant downturn in the credit cycle. A bank with a rapidly deteriorating credit book and thin reserve levels could find that it has effectively overstated its capital strength. We have supplemented our capital table with some key credit metrics across the Large-Cap Canadian banks (Exhibits 2 and 3).

Capital to remain a key focus. Overall, in our view the group is comfortably positioned by most capital measures, particularly given the outlook for still sizable earnings generation in 2009 and a fairly clean slate of risks/exposures. The group is amply ahead of regulatory requirements although market expectations appear to have risen in recent weeks. A recent release from the country's regulator, OSFI (December 19, 2008), was in our view an effort to talk down expectations regarding the need for higher capital levels. The regulator said explicitly that it had not pushed for higher capital levels across the board and underscored that capital levels are not intended to be pro-cyclical and are expected to provide a measure of cushion through down turns.

That said, we believe the reality is that investors, rating agencies and regulators will remain biased in favor of more, not less, capital in the near-term. Therefore we expect the group to conserve capital by holding the line on existing dividends (although not cutting), managing asset growth, raising regulatory capital where possible and potentially adding additional common equity in select cases, namely Scotiabank and National Bank which have resisted coming to market under pressure.
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The Globe and Mail, Tara Perkins, 27 December 2008

Many executives will remember 2008 as among the most stressful years in their career, but none more so than banking executives.

The world's banking system was brought to its knees this fall. For Gordon Nixon, CEO of the country's biggest bank, that meant being on constant guard for the next potential crisis and taking action to reduce the bank's exposure to it.

This month, Mr. Nixon decided to bolster the bank's protective defences by raising $2.3-billion in common equity to boost its capital levels. Moves by Canada's big banks to increase capital have been criticized by Bank of Canada Governor Mark Carney, who along with Finance Minister Jim Flaherty is urging the banks to step up lending. But the banks are facing pressure to do the opposite. Like its counterparts around the world, the bank is increasing its provisions for bad debts because it appears consumers and businesses will struggle in 2009. But Mr. Nixon says Canada heads into this period in a much better position than previous downturns.

What is happening in Canada's credit markets?

There is no question that, statistically, Canadian banks are continuing to lend and you are seeing very strong loan growth basically across all sectors. Having said that, there is also the reality that credit has tightened up globally and we've had many providers of credit withdrawing or disappearing from the marketplace.

How does 2008 compare to previous downturns you have been through?

I don't think any of us have lived through a downturn like this. It's been very different, and probably more so for those of us in the financial services industry because the first half of 2008 was a banking crisis, while the second half of 2008 has become a much more widespread economic crisis.

What was the biggest surprise?

I think that the biggest surprise was the systemic impact on the financial services sector and the credit markets as a result of the decline in U.S. residential real estate. A lot of people were expecting a correction, ultimately, in the residential real estate market in the U.S. given the performance in the last couple of years, but I don't think anybody - or very few - suspected the systemic impact that that would have across the financial system. It was just staggering to see the complete withdrawal of confidence and liquidity from the marketplace.

Was there one moment that stands out as the scariest?

One of the toughest things this year was that it was just so unrelenting. Weekend after weekend there would be a crisis, day after day there would be another issue in the marketplace. I think the most important period was the weekend of the IMF meetings, when the G8 members and really the broader G20 came together and came out of that weekend with a plan to provide stability to the banking system. I think it will be looked back on as the turning point with respect to the financial crisis.

What is the wisest move that policy makers have made?

The co-ordinated efforts that occurred across the system. Here in Canada there was a high degree of communication, which I think served the system quite well, and I think it was very important to see the central bankers and finance ministers and governments pull together. The other thing which has been quite remarkable has been the speed and decisiveness with which the American government, the Federal Reserve and the Treasury have been able to institute policy and programs in the marketplace.

What mistakes have they made?

This has been a new process for all policy makers and to some degree part of it is experimental. Sometimes it works, sometimes things don't work as well.

There is no question that the collapse of Lehman Brothers was instrumental in terms of amplifying the systemic nature of the problems. ... Whether Lehman should or shouldn't have been allowed to file for Chapter 11 will be something that I think economists will be debating for 100 years.

What should the system learn as it comes out of 2008?

There's no question that bubbles were created in various markets. ... We had a world where financial assets were growing at a much faster rate than either financial earnings or the economy in general, and it created a situation where there was way too much leverage in the system. And, like every other bubble, it reached a point where it burst; it's just that, with this one, the implications were much more dramatic. Over the next five years, hopefully longer, there will be a much higher priority placed on risks-to-rewards and it will have significant implications on compensation, risk standards, regulatory measurement, regulatory reform.

What is the biggest issue you are watching going into 2009?

One of the things we'll be watching and that the marketplace will be watching very carefully is general credit. As opposed to accounting volatility as a result of securities going up and down, which was clearly a theme for 2008, in 2009 there will be much more focus on credit - what's happening in credit card portfolios and personal loans and the manufacturing sector.

How is Canada positioned for 2009?

We go into this recession fiscally in a very different position than we went into previous recessions over the last 40 or 50 years. Unemployment is at historically low levels, interest rates are much lower, you've got a strong banking system. There are a whole bunch of factors that I do think put Canada in a much stronger relative position to weather this storm than we have been historically.

Looking Ahead

The threat

Royal Bank of Canada is coming out of an unprecedented banking crisis, and the withering economy promises to have an impact on the banking sector in the year to come. The impact

Losses from bad loans are expected to rise across the sector next year as borrowers struggle with their debt loads.

The reaction

Executives at the country's biggest bank are carefully watching its loan portfolios for signs of trouble, but have not cut back on lending
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Sunday, January 04, 2009

2008 League Table

  
The Globe and Mail, Boyd Erman, 5 January 2009

Share issues by Canadian banks helped shore up an otherwise dismal year for securities firms, with total sales of $30.3-billion coming in one-third below 2007's performance.

The busiest securities firms in Canada last year were those raising money on behalf of their bank parents. Bank issues accounted for $7.7-billion as four of Canada's Big Five banks tapped markets to strengthen their sagging balance sheets, according to figures compiled by Thomson Reuters.

Most of the action came in the final three months of the year, when such insurers as Manulife Financial Corp. and Great-West Lifeco Inc. joined the parade of financial institutions seeking funds. The final quarter also brought a wave of stock sales from utilities.

"Normally you might see a couple of billion-dollar deals a year," said Phil Smith, the deputy head of global investment banking at Scotia Capital Inc. "Well, we were seeing one a week there for a while, which is really extraordinary."

Even so, total issuance of stock fell by a third to $30.3-billion in 2008 compared with 2007.

RBC Dominion Securities Inc. was one of the biggest beneficiaries of parental largesse, raising the most money of any investment bank in 2008. It managed share sales worth $4.6-billion, but half that tally came from running a $2.3-billion sale for parent Royal Bank of Canada.

When deals for parent banks are stripped out of the data to give the true picture of which firm won the most business from outside clients, Scotia Capital was the leader with a total of $2.65-billion raised due to a focus on utilities and insurers. Scotia, whose parent bank did not sell common shares in 2008, led Manulife's $2.3-billion December share sale.

For big banks such as Bank of Nova Scotia, the fourth quarter salvaged an otherwise dismal year. But for the smaller, independent brokerages like Canaccord Capital Inc. and GMP Securities that flourished during the commodity bull run, 2008 was just plain dismal.

The outlook for all sectors of the market is still murky. Notwithstanding the big finish to 2008, it's no sure thing that the momentum will continue into 2009. Until markets settle down, it will be tough for anyone but the most-established companies such as banks and utilities to raise money. And even then, there's a question of how much investors will buy.

There are probably a couple more bank sales in the offing. National Bank of Canada is likely to sell equity, analysts forecast, to bring up its capital level, and there's talk that at least one other major bank that has already sold shares will have to come back seeking more cash. The odds-on favourite is Toronto-Dominion Bank if there are further losses in its U.S. loan portfolio.

It's a buyers' market, though, and for the moment there are signs that the heap of stock sold in recent months has sated investors' demand.

"There's generally appetite, the cash flow is pretty good, but you can't be hitting people with a ton of product in a short period of time," Scotia's Mr. Smith said.



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